Interest rates a pointer to investment climate

ET Bureau|

Jun 26, 2009, 03.06 AM IST

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MUMBAI: It is almost a weekly ritual now. Inflation plunging to historical lows; finance minister asking bank chiefs to examine whether there is room for further cut in interest rates, and a few days later a clutch of banks announcing lower rates. Have you ever wondered what is it all about? Sure, you don���t need a math wizard to tell you that you would earn less on your bank fixed deposits. But did it ever cross your mind that a lower (or a rising) interest rate can be useful pointer towards your investments, especially in mutual funds?

���Inflation and interest rate for most people have an immediate impact on their shopping and fixed deposits, but that is not the case. An interest rate environment also tells you a lot about the investment climate,������ says a wealth manager with a bank.

���In fact, it is a useful tool for investors to gauge and predict both equity and debt investments,������ he adds. For example, every investment expert worth his tie would tell you that a lower interest rate regime is great news for equity market. Why? Because companies can borrow cheaply, build capacity and make money. That means their stock prices would be on fire on Dalal Street.

(The current scenario is bogged down by issues like global recession and crisis of confidence and so on.) ���It is generally considered that lower interest is good for the equity market because traditional investments like bank deposit would earn less money. This means there will be a tendency among investors to transfer money into equity mutual funds,������ says Hemant Rustagi, CEO, Wiseinvest Advisors. ���It doesn���t mean that it is a strategy that always works or investors who get into the market this way becomes equity investors. It is a trend that you can observe when there is easy interest rates.������

Debt investors don���t have to lose heart. Lower interest rates don���t mean doom for debt mutual funds at all. In fact, they also tend to do extremely well in a falling interest rate regime. Surprised? Well, this is because of the inverse relationship between bond yields (debt schemes invests in various kinds of bonds) and bond prices. When falling interest rates, bond yields also fall in tandem with them and that would push up the prices of bonds.

When the prices of bonds go up it will be reflected in the net asset value (NAV) of debt schemes. ���Debt schemes have always done well during a falling interest rate environment. In fact, investors tend to get carried away because of the extraordinary returns these schemes offer during a temporary phase,������ says an investment consultant.

That brings us to the reversal. Sure, a modest interest rate regime is always preferable in an economy like ours, but due to various factors the interest rates can rise. This also has a bearing on the investment scenario. For example, the stock market is likely to become cautious as there is always a fear that capex plans may be scaled down, hitting profitability. Which means those stocks would be hit on bourses.

���In fact, more than equity it is debt investment which is more susceptible to interest rates,������ says Rustagi. ���If you stay invested in a debt scheme for a long period when rates are falling, you would lose money. In a rising interest rate environment, investors should consider parking money in fixed maturity plans or floating rate schemes,������ he says.